What is reverse causality in finance research?

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AcadiFi · Accepted Answer

Reverse causality (endogeneity of direction) occurs when we observe correlation between X and Y and conclude X causes Y, but Y actually causes X — or both are driven by a third factor. Example: Pemberton Research publishes a paper showing firms with high ESG ratings outperform peers by 2.1% annually. Claim: ESG practices cause outperformance. Counter-claim: firms that are ALREADY profitable have cash and management bandwidth to invest in ESG initiatives — profitability causes high ESG scores, not the other way around. Similarly: (1) high-dividend stocks outperform — or do firms that happen to generate strong cash flows both raise dividends AND outperform? (2) analyst coverage correlates with returns — but analysts cover the stocks that are already interesting. (3) firms with independent boards outperform — but well-performing firms can afford more independent directors. Solutions: instrumental variables (find a variable correlated with X but not Y except through X), regression discontinuity designs, natural experiments (policy changes), lagged variables, Granger causality tests. CFA Level II candidates should recognize that correlation in cross-sectional data rarely establishes causation without careful identification strategies.

What is reverse causality in finance research?

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